Activision: Skilled Player
The prize for video-game developers over the next few years is clear: The opportunity to sell millions of games that will run on Microsoft's new Xbox 360 and the soon-to-arrive next-generation consoles from Nintendo and Sony. But just as in an adventure video game, getting to that big prize involves traversing treacherous terrain.
Activision, the second-largest video-game maker, is in the middle of this tough mission. Its share price has fallen more than 20% since November, as investors began to worry that the path to the game industry's next big cycle was filled with challenges. The company, which earned 50 cents per share in the fiscal year that ended March 2005, is expected to lose money over the next few quarters, as it develops games compatible with the new consoles and consumers put off buying old games in anticipation of the new releases. But Bear Stearns analyst R. Glen Reid says that Activision is a skilled player and that it has a strategy that will enable it to come out a winner in the end.
Reid says that game makers as a group should benefit from strong market growth over the next several years as more people play video games -- and pay premium prices for the next-generation programs. Mobile gaming should also start to take off. The downside to sophisticated next-gen products, however, is that they cost significantly more money to develop -- an average of $20 million per game, according to Reid, or double the cost for games developed during the 2000-2005 cycle. So although revenues should grow robustly, Reid says, development costs will weigh on the companies' profitability. The key to success, in his view, will be a company's ability to gain market share -- something he believes Activision will be able to do. He upgraded the stock to "outperform" on Tuesday.
Reid says the Santa Monica, Cal., company should be able to produce both above-average revenue and earnings growth. Not only should it be able to overpower smaller competitors, he says, but its management team also "understands how to succeed at retail and international markets." Activision has scaled back new releases for this year, as it navigates the industry transition. And there's plenty of opportunity for overseas growth -- Activision's international sales, according to Morningstar, are one-fourth those of its larger rival, Electronic Arts.
Although Reid thinks Electronic Arts should also be able to significantly increase its share of the market, he believes the Street is overestimating its earnings potential. He points not only to game-development costs but also to heavy spending on licenses for sports-related games. He rates EA "underperform."
Activision's stock (ATVI) jumped 5% on Tuesday, to $14, after Reid's upgrade. Analysts, on average, expect Activision to earn 15 cents a share for the fiscal year that ends next March, according to Thomson First Call. At its current price, the stock sells for 91 times estimated earnings, a sky-high figure that's not terribly meaningful given Activision's depressed profits. Reid thinks earnings will grow to 30 cents per share in fiscal 2008, and he sees the stock hitting $16 by the end of this December.